Walgreens' Antitrust Rx Is Addition by Subtraction

Walgreens Boots Alliance' (WBA) bid to acquire Rite Aid (RAD) , the No. 3 U.S. pharmacy retailer, would solidify the buyer's spot as the country's biggest drug store chain in terms of total stores and prescription sales. The acquisition, announced in October, also would be a test of different business models for the two remaining large traditional drug chains.

Rival CVS Health (CVS) in recent years has branched out into additional segments of the pharmacy business by buying a large presence in both pharmacy benefit management and specialty retailing in nursing homes. But Walgreens Boots Alliance, with its $17.2 billion acquisition ($9.5 billion plus debt) of Rite Aid, is continuing to put nearly all of its chips on traditional retail, a bet Walgreens has continually raised since it bought New York's Duane Reade Holdings in 2010. It subsequently increased its reliance on retail by shedding its pharmacy benefits manager, Catalyst Health Solutions, in 2011 and merging with Switzerland-based pharmacy retailer Alliance Boots at the end of 2014. Even Walgreens' wholesale business, acquired with Alliance Boots, is tied to traditional retail as it supplies independent pharmacies and small drug store chains.

Because of Walgreens' decision to stick with an almost purely retail strategy, its plan to acquire Rite Aid will be judged by antitrust regulators in the U.S. along the lines of other major retail mergers that have occurred or been attempted in recent years, including Staples' (SPLS) government-contested bid to acquire Office Depot (ODP) , Dollar Tree's (DLTR) acquisition of Family Dollar Stores, Dollar General's (DG) unsuccessful and unsolicited attempt to supplant Dollar Tree, the Albertsons grocery chain purchase of Safeway and Men's Wearhouse's (MW) 2014 acquisition of Jos. A. Bank Clothiers.

The review illustrates a significant regulatory challenge facing would-be dealmakers, one that is likely to grow in importance along with the size and scope of M&A activity, at least in health care. Mergers like that of Walgreens' and Rite Aid, which raise issues of "horizontal" competition in so far as the acquisitions would primarily consolidate sales outlets, may be more difficult to get past regulators than those involving "vertical" competition, where potential consolidation would occur primarily along the chain between supply and distribution. But if, as expected, Walgreens can allay antitrust concerns through divestitures, then even heavily horizontal deals may be worth pursuing, especially in cases where, like Walgreens, the buyers may say good riddance.

Call it the addition-by-subtraction solution to antitrust worries.

In each of the above-mentioned retail deals, the Federal Trade Commission carried out an intense store-by-store competitive analysis of direct competition faced by the merging parties to determine whether and where any locations would need to be divested. In some cases the parties were told they'd have to pare thousands of locations, in others no divestitures were required at all and in yet other deals the divestiture requirements fell somewhere in between.

The purely retail nature of the transaction sets it apart from CVS's recent high-profile deals -- last year's $12.7 billion acquisition of Omnicare, the country's leading provider of pharmacy services to nursing homes, and its 2007 acquisition of PBM Caremark RX. Both of those deals were cleared by the FTC with no conditions despite concerns raised by public advocates and third parties about possible vertical competition issues presented by CVS's entry into other segments of the drug delivery chain.

But by acquiring a large direct competitor, Walgreens is unlikely to get such an easy ride from the FTC, and its merger agreement with Rite Aid reflects that. The buyer has pledged to divest of as many as 1,000 stores with a market value up to $100 million in order to win antitrust clearance. The deal has an Oct. 27, 2016, termination date that can be extended until Jan. 27, 2017.

Walgreens must also pay Rite Aid a $325 million termination fee if the merger fails to receive regulatory approval. At just under 2% of the deal value, that's a relatively small reverse breakup fee and an indication that the parties are confident they can address the antitrust issues with the FTC. Walgreens is being represented by Weil, Gotshal & Manges partners Steven Newborn and Steven Bernstein, counsel Vadim Brusser and associates Angela Diveley and Brittany Constance.

Walgreens currently operates more than 13,100 stores in 11 countries and is the largest retail drug chain in both the U.S. and Europe. The company also operates one of the largest global pharmaceutical wholesale and distribution networks with over 350 distribution centers delivering to more than 200,000 pharmacies, doctors, health centers and hospitals each year.

Its own retail stores now comprise 85% of Walgreens' sales compared to CVS, which derives only 43% of its sales from stores. CVS gets the bulk of its sales from Caremark, the country's second-largest PBM, and other services offered by its Pharmacy Services segment, whose clients are primarily health insurers and employers rather than retail customers.

With the acquisition, Walgreens will be acquiring a reasonably sized PBM, EnvisionRX, that Rite Aid bought in June, but it has only a modest share in the market. There is speculation that the company might use EnvisionRX as a launching pad to get back into the PBM business in a big way. Others predict Walgreens will simply try to sell it. For their part, Walgreens officials have not addressed plans for the unit.

And at the moment, Walgreens officials have said the entire focus will be on expanding the retail footprint and using the newly acquired scale to make stores more competitive relative to other retail druggists.

"We very much see the Rite Aid acquisition... as creating a high-quality retail pharmacy choice for U.S. consumers," Walgreens CFO George Fairweather said during a presentation to Morgan Stanley Global Consumer & Retail Brokers Conference on Nov. 17. The combination enables Walgreens to accelerate efforts to establish national coverage rather than limiting itself to buying small chains, he said. "It lets us get there much quicker in a market that's evolving rapidly."

He then laid out what the company is doing to improve store operations: "Streamlining our product categories, minimizing some of our loss-leading promotions, reducing areas like stocks, stock losses, really basic retailing skills." The company is also testing how it will differentiate its beauty and other non-pharmacy offerings, or "front-of-store" as these products are called in the drug store business. "We very much believe that you have to have a differentiated offering," he said.  That includes stocking premium in-house labels such as its No7 skin care line beside leading brand names. "It is a real premium product that we are able to sell at a sort of mid-price point. And of course, we are able to hold the full margin on that."

Richard Feinstein, an antitrust partner at Boies, Schiller & Flexner and a former Competition Bureau director at the FTC, said the companies were wise to give themselves at least a year to get the deal through the antitrust process. "This is going to be a long, fact-intensive investigation," he said "It doesn't surprise me that they are obligated to hold it together for a year or more."

The commission is likely to follow a predictable path in analyzing the deal's impact on competition, he said. The staff will rely on a heavy dose of economic study to predict how it will affect drug store pricing in geographic zones. Because every customer purchase is recorded, the FTC can examine where each store's customers are coming from, how they respond to price promotions, the extent to which any store's pricing is affected by another store's and how far apart stores must be in order to not impact each other.

All of that data will be used to determine the number of stores that will need to be divested and who the right buyer should be.

A complicating factor in the investigation will be the presence of grocery chains and big box retailers like Walmart (WMT) in the pharmacy market, Feinstein said. Many of these stores have full-service pharmacies but grocery aisles won't necessarily provide an apples-to-apples comparison with the drug chains' front-of-store offerings. (Target's (TGT) $1.9 billion sale of its pharmacy and clinic businesses to CVS announced in June will also add a wrinkle that the FTC will have to account for.)

Garrick Brown, vice president of retail research for the Americas at real estate broker Cushman & Wakefield, predicted that the FTC will require Walgreens to divest of between 500 and 700 stores. The two companies combined have 12,800 stores in the U.S. He found that there are 3,100 zip codes with where there are at least two stores of either brand and 400 where there are four or more. The most intense geographic overlap between the two companies' stores is in Michigan, Pennsylvania and New York, with California and Ohio also seeing substantial overlap. There are 14 states where Walgreens' market presence would at least double.

Finding suitable buyers for stores ordered to be divested might be the hardest task for the companies. There is really no other large U.S. drug store chain that could absorb the locations to be divested on its own. As a result, Brown sees strategic buyers such as Canada's biggest drug store chain, Shoppers Drug Mart, as a potential candidate. Also, he said any number of private equity shops might be interested in pairing spun-off locations with one of the few remaining regional chains such as Bartell Drugs in the Pacific Northwest.

"I have a feeling some PE group is going to emerge and buy up a huge swath of these stores and form a new entity," Brown said. "I've gotten inquiries from at least 10 different private equity groups interested in buying big chunks of them."

Brown predicted that most of the spun-off stores will be from Rite Aid as the company has a large stable of locations acquired during its last growth spurt in the 1990s and early 2000s, which have as much as 40,000 to 50,000 square feet per store. Walgreens' template calls for stores to be much smaller, roughly 16,000 square feet.

"They want to maximize sales per square foot and have a template they like and merchandise for," he said.

Brown also suspects that Walgreens actually wants to shed much more than the amount the FTC will determine is necessary to protect competition in order to maximize sale per square foot -- perhaps as many as 3,000 total. A bigger divestiture package might be more attractive to the right buyer or buyers would give the FTC even more comfort with the Rite Aid acquisition. "It would be an easy way to get a new, big competitor out of thin air," he said.

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